Tuesday, October 28, 2008

After reaching 38% of GDP during World War II, defense spending dropped below 5% of GDP in the years immediately following the war, rose to nearly 15% at the start of the cold war as the US rearmed and built up its stock pile of atomic weapons, declined through the late '50s and early '60s to 7%, jumped again during the Vietnam War to 10%, declined throughout the '70s and early '80s, headed up again during the Reagan era of rearmament as we spent the Russians into state failure, droped again in the late '80s and early '90s until Desert Storm, declined until the beginning of the millennium until 9/11 when it rose steadily to almost 5% of GDP in 2008.

It looks like credit woes are pretty much the same around the world. The Indian middle-class, enjoying rising prosperity, has gotten caught up in fast-rising revolving credit card debt that they seem to little understand and have difficulty managing.

Unsecured loans and credit card receivables more than three months overdue: 7%-9% of total loans outstanding this year; expected to rise to 15% according to ratings agency Crisil Ltd. in Mumbai.

Number of credit cards in India: 30 million, up 3x in the last 5 years.

At the end of FY '08 (ended March 31) Indians charged more than $14 billion on their credit cards, over 3x the amount charged four years ago.

Indians have little experience with handling revolving credit and more people are turning up desperate for help with their credit card payments, according to V.N. Kulkami, chief counselor at Mumbai's Abhay Credit Counseling Center, which advises borrowers.

The nominal definition of a bear market is one in which securities prices drop 20% over a period of time. In today's Wall Street Journal Arthur B. Laffer reminds us what a real bear market is:

I saw up close and personal Presidents Gerald Ford and George H.W. Bush succumb to panicked decisions to raise taxes, as well as Jimmy Carter's emergency energy plan, which included wellhead price controls, excess profits taxes on oil companies, and gasoline price controls at the pump.

The consequences of these actions were disastrous. Just look at the stock market from the post-Kennedy high in early 1966 to the pre-Reagan low in August of 1982. The average annual real return for U.S. assets compounded annually was -6% per year for 16 years. That, ladies and gentlemen, is a bear market. And it is something that you may well experience again. Yikes!

Laffer has a new book out on the subject: "The End of Prosperity: How Higher Taxes Will Doom the Economy--If We Let It Happen"

Laffer says we are making the same mistakes as previous generations of politicians, whether Republican or Democtratic, with hasty solutions cooked up under panic conditions that will set the stage for "the end of prosperity".

The main problem with the modern financial system based on widespread use of derivatives and securitization is that while financial specialists understand how individual assets function, even they have little understanding of how the whole incredibly complex financial system operates when exposed to various types of stress.

Like many exotic financial products which are extremely complex and profitable in times of easy credit, when markets reverse, as has been the case since August 2007, in addition to spreading risk, credit derivatives, in this case, also amplify risk considerably.

Now the other shoe is about to drop in the $62 trillion CDS market due to rising junk bond defaults by US corporations as the recession deepens. That market has long been a disaster in the making. An estimated $1,2 trillion could be at risk of the nominal $62 trillion in CDOs outstanding, making it far larger than the sub-prime market.

No regulation

A chain reaction of failures in the CDS market could trigger the next global financial crisis. The market is entirely unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb. The US Federal Reserve under the ultra-permissive chairman, Alan Greenspan and the US Government’s financial regulators allowed the CDS market to develop entirely without any supervision. Greenspan repeatedly testified to skeptical Congressmen that banks are better risk regulators than government bureaucrats.

Use of Credit Derivatives to Transfer Risk outside the Banking SystemPerhaps the most significant development in financial markets over the past ten years has been the rapid development of credit derivatives. Although the first credit derivatives transactions occurred in the early 1990s, a liquid market did not emerge until the International Swaps and Derivatives Association succeeded in standardizing documentation of these transactions in 1999. According to the BIS, the notional value of credit derivatives outstanding increased sixfold between 2001 and 2004, reaching $4.5 trillion in June of last year. Moreover, this growth has been accompanied by significant product innovation, notably the development of synthetic collateralized debt obligations (CDOs), which allow the credit risk of a portfolio of underlying exposures to be divided or "tranched" into different segments, each with different risk and return characteristics. Recent growth of credit derivatives has been concentrated in these more-complex structured products.

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers. But some observers argue that what is good for the banking system may not be good for the financial system as a whole. They are concerned that banks' efforts to lay off risk using credit derivatives may be creating concentrations of risk outside the banking system that could prove a threat to financial stability. A particular concern has been that, as credit spreads widen appreciably at some point from the extraordinarily low levels that have prevailed in recent years, losses to nonbank risk-takers could force them to liquidate their positions in credit markets and thereby magnify and accelerate the widening of credit spreads.2

A definitive evaluation of these concerns about nonbank risk-takers would require information on the extent of credit risk transfer outside the banking system and on the identities and risk-management capabilities of the entities to which the risk has been transferred. Unfortunately, available data do not provide this information.

ZenithOptimedia today lowered its forecast for advertising growth both in the US and worldwide.

Zenith, whose forecasts are closely followed by the industry, said it expects ad spending in the U.S. to grow just 1.6% this year and by less than 1% in 2009. In June, the ad-buying firm, a unit of Publicis Groupe, predicted growth of 3.4% and 2.6%, respectively, for this year and next.

World-wide, Zenith says it now expects ad spending to grow 4.3% to $506.3 billion this year and 4% in 2009. In June it predicted 6.6% growth for 2008 and 6% growth for 2009.

Monday, October 6, 2008

According to the government, there are 35 working public ambulances with life-saving equipment to serve the needs of a population of over 14 million in New Dehli, India. This greatly contributes to the loss of life during terrorist attacks when the "golden hour" turns into the "golden four hours".

Thursday, October 2, 2008

I was amazed to discover to what extent demand for commodities world-wide is driven by growth in China. In 2009 Deutsche Bank forecasts that almost 100 per cent of the growth in demand for aluminum, around 80 per cent of the growth in demand for iron ore, oil, and steel, and 60+ per cent of the growth in demand for copper will come from China.

Forecast of China's Share of the Growth in Demand for Commodities Worldwide in 2009

Although growth of the Asian manufacturing economies of India and China has slowed in response to slowing global markets and the recent credit crash, commodity prices remain high. Economist Jeffrey Frankel believes that that low real interest rates have been the cause as the continued strength of commodity prices:

One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favoured: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:

by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)

by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks), by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates were high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.” (http://www.voxeu.org/index.php?q=node/1002)

U.S. auto sales reached a 15-year low with a double digit decline in September as sales of cars and light trucks fell 27% to 964,873 units in September (2008), down from 1.31 million a year earlier, according to Autodata Corp. Tightening credit, a financial system in shambles, and consumer fear all contributed to a seasonally adjusted annualized rate of 12.5 million units, down from 16.19 million units in September 2007.

Piracy off the coast of Somalia has more than doubled in 2008; so far over 60 ships have been attacked. Pirates are regularly demanding and receiving million-dollar ransom payments and are becoming more aggressive and assertive.

The international community must be aware of the danger that Somali pirates could become agents of international terrorist networks. Already money from ransoms is helping to pay for the war in Somalia, including funds to the US terror-listed Al-Shabaab.

The high level of piracy is making aid deliveries to drought-stricken Somalia ever more difficult and costly. The World Food Programme has already been forced to temporarily suspend food deliveries. Canada is now escorting WFP deliveries but there are no plans in place to replace their escort when it finishes later this year.

The danger and cost of piracy (insurance premiums for the Gulf of Aden have increased tenfold) mean that shipping could be forced to avoid the Gulf of Aden/Suez Canal and divert around the Cape of Good Hope. This would add considerably to the costs of manufactured goods and oil from Asia and the Middle East. At a time of high inflationary pressures, this should be of grave concern.

Piracy could cause a major environmental disaster in the Gulf of Aden if a tanker is sunk or run aground or set on fire. The use of ever more powerful weaponry makes this increasingly likely.

There are a number of options for the international community but ignoring the problem is not one of them. It must ensure that WFP deliveries are protected and that gaps in supply do not occur.

Update, November 18, 2008: Somali pirates have hijacked a Saudi supertanker carrying a cargo of $100 million in oil. The capture of Sirius Star 450 nautical miles southeast of Kenya's Mombasa port, and way beyond the Gulf of Aden where most attacks have taken place this year, is their boldest attack and the culmination of several years' increasing activity.